LPC: BDC leverage cap increase back on table after bipartisan vote

NEW YORK (Reuters) - The US House Financial Services Committee on Wednesday overwhelmingly voted to advance a bill that would update rules governing Business Development Companies (BDCs), paving the way for the specialized lenders to make more loans to small and mid-sized businesses.

The legislation would provide relief to BDCs by amending the Investment Company Act of 1940 for the first time since the 1980s. If enacted, the bill would allow BDCs to deploy more capital as well as streamline burdensome Securities and Exchange Commission (SEC) offering and registration processes.

Members of the Financial Services Committee voted 58-2 to adopt H.R. 4267, the Small Business Credit Availability Act, in a rare show of bipartisan support. Full House and Senate votes are still required.

“This is one of the few bills, financial services-related or otherwise, that has broad-based support across the full spectrum on both sides of the aisle. The vote showed support from the left, right and center, and from representatives in leadership roles,” said Mike Gerber, executive vice president corporate affairs, at asset manager FS Investments, which manages over US$20bn in assets including US$18bn across five BDC funds.

The bill is sponsored by Representative Steve Stivers (R-OH) and co-sponsored by four democrats and three republicans including Representative Gwen Moore (D-WI), Representative Patrick McHenry (R-NC) and Representative James Himes (D-CT). Himes notably voted against a prior measure in 2015 before subsequently lending his support to the 2017 bill as a co-sponsor.

Legislative efforts to modernize the regulatory regime governing BDCs, including raising the leverage limit, have seen increasing levels of support since 2013. This is not the first time such a bill has been advanced out of committee, but previous measures have stalled before being put to full House or Senate votes.

TWO TO ONE

Currently leverage for BDCs is capped at a ratio of 1:1 total debt to equity. In other words, BDCs are not permitted to borrow more than one dollar for every dollar of assets the fund owns. If the bill is signed into law it would allow BDCs to employ leverage up to two times total debt to equity.

Asset coverage rules for BDCs are far more restrictive compared to other lending vehicles, including traditional banks as well as Collateralized Loan Obligation funds. Even at leverage of 2:1, market participants note that BDCs would be one of the lowest and most conservatively levered vehicles in the market.

Increasing the leverage limit would allow BDCs, which are a significant source of funding for small and medium-sized businesses, to deploy more capital to borrowers. With additional leverage BDCs could continue generating competitive returns while still focusing on senior investments at the top of the capital stack instead of sometimes moving down the risk spectrum to junior debt.

The middle market lending landscape has attracted record amounts of capital in the last two years as investors seek exposure to higher yielding assets in a low interest rate environment, creating an intensely competitive investment and underwriting environment.

A record US$60bn was raised in 2016 across middle market CLOs, BDC equity raises, as well as other new and existing senior loan funds and direct lending strategies. This year is on track to match that record with another US$57bn in middle market fundraising already recorded, according to Thomson Reuters LPC data.

“Private loan funds are raising limited partner equity capital that can easily be levered at 2:1. BDCs are currently trying to compete with that on a 1:1 basis and sometimes have to move down the balance sheet to create yield, but that can also mean increased risk,” said Vince Foster, chairman and CEO of Main Street Capital, a publicly-traded BDC.

As the middle market evolves and there are more platforms and more dollars chasing deals at very competitive rates, the legislation is seen benefitting BDC shareholders as managers can generate competitive yields while maintaining or reducing risk appetite.

EYES ON THE SENATE

Supporters of the bill are encouraged by the bipartisan backing, and are optimistic the US Senate can secure the same level of approval.

“A 58-2 vote in committee sends a strong bipartisan message in an environment where it is hard to find common ground. Mid-sized businesses are the primary engine of job creation in the US economy, and both sides of the aisle got behind that notion,” said Joseph Glatt, co-founding member of the Coalition for Small Business Growth. “We are hopeful the Senate will take swift action joining their colleagues in the House to come up with a similar measure.”

BDCs currently have over US$80bn in outstanding investments in middle market businesses, according to the Small Business Investor Alliance (SBIA). Middle market firms are responsible for more than half of US job growth since 2011, the SBIA said, noting that BDCs provide vital growth capital to these companies.

BDC analysts were more circumspect with respect to the likelihood the changes are enacted.

“We think the headline of the bill passing the committee is a positive for BDCs but similar legislation has moved in the House before,” Keefe, Bruyette & Woods analysts wrote in a research note on Thursday. “In our view, the Senate has been and continues to be the bigger political hurdle. Therefore, until we see signs of a breakthrough in the Senate to support this bill, we think chances it becomes law are low.”